It’s Only A Paper Moon, And It’s Only A Paper Loss

Take any basic accounting class, or go to Vegas for the weekend, and you’ll soon get the concept that financial losses are bad. Which is why you might scratch your head when I tell you that some of my most successful property investment clients ask me to find them properties that will show a loss.

I was recently discussing this concept with a colleague, when he smiled knowingly and said, “I get it, your client’s getting divorced and wants to hide some money.” After assuring him that this wasn’t some film noir-style fraud scheme, I explained that my client was talking about “paper losses.” The quizzical tilt of his head told me that I had some ‘splaining to do.

On the face of it, rental property is a simple investment: Rent comes in, you deduct your expenses, and if you’ve invested correctly, you have money left over to put in the bank. Easy peasy. But if that’s all you’re doing with your rental, you’re not taking advantage of the greatest benefits of income properties, namely “straight line” depreciation and the mortgage interest deduction.

Depreciation can be a difficult concept to get, especially when you consider it’s completely legal, but here goes. The US government recognizes that some assets lose value over time. As a matter of fact, some lose so much value that they eventually have no value at all. Let’s take computers, for example. If you buy a computer for work, the IRS allows you to depreciate, or subtract part of the value of, the computer over a five year period. So, if you bought a computer for $2,000, each year on your taxes you could “claim” a $400 dollar loss, as if you actually spent this money as an expense, until the computer was (according to the IRS) worth nothing. The thing is, we all know a computer doesn’t just give up the ghost and dies after five years (as a matter of fact, I’m writing this on a seven year old MacBook), but according to the tax code, the useful life of my Mac is only 5 years.

If you’re thinking, “That’s nice, but we’re talking about real estate,” bear with me. The tax code also allows for depreciation of buildings. In the case of residential properties, the depreciation period is 27-1/2 years. That means for a building with a value of $500,000, the IRS allows you to deduct $18,182.00 each and every year. Keep that figure handy…

Let’s say that you get $2,000 a month rent on a condo unit. And you have $800 of actual monthly expenses. That leaves you with $1,200 each month, or $14,400 dollars a year in taxable profit. Now, with almost any other investment you’d be paying tax on that profit. And if that’s all the accounting you did with your property, you’d be paying that tax as well. But because you have a good accountant, she remembers to subtract the depreciation of $18,182. She sharpens her pencil and sets up the following math problem:

$14,000 – $18,182 = (- $3,782)

And you find yourself smiling as she explains that the tax code allows you to show a loss of close to $3,800 and that’s what you’re putting on your taxes. And as they say on TV commercials for kitchen gadgets, “But wait, that’s not all!” If you have a loan on the property you can deduct the interest from that loan as well. So, let’s say you’ve paid $3,000 in interest, you’re now showing a paper loss of -$6,782.

And now it gets even better, because you also own another rental condo free and clear. And even though the rent is so high that you have a profit of $10,000 a year even after calculating depreciation, you get to run your “loss” from the first unit against that $10K, so now, according to the IRS, you only owe taxes on $3,218. To be very clear, you don’t owe $3,218 in taxes, you owe the taxes on $3,218. Pretty cool, right?

Because of the tax and accounting advantages, I work with my clients and their CPAs to design multi-unit income property portfolios, even if we build them one unit at a time.

In a future post, I’ll tell you the spine-tingling and exciting tale “Old Man Jones and the Mystery of the Cash-out Re-Fi.”

Please keep in mind: 1) The numbers used above are purely for illustrative purposes; and 2) I’m not an accountant or a tax attorney, so if you are thinking of investing, please consult with a tax professional to make sure that the numbers work for your individual investment and tax planning goals.